IT Is Recovering, Bit By Bit

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Standard & Poor's Ratings Services continues to expect 2004 to be a year of moderate overall growth in technology spending, estimated in the low- to mid-single digits. An improving economy, coupled with more balanced industry inventories and a focus on cost cutting, bode well for more stabilized credit quality. While some categories -- like semiconductors -- will see very solid year-over-year revenue growth, others, such as telecommunications equipment, will be flat to modestly positive.
However, continuing pricing pressures across almost all sectors, combined with an improving but still cautious corporate IT-spending environment, indicate the negative-rating trend for IT outfits from 2003 may moderate. But it's not likely to reverse over the near term.
More technology companies with excess liquidity may step up shareholder distributions, as both Microsoft (MSFT; corporate credit rating, AA; rating outlook, stable) and Hewlett-Packard (HPQ; A-; stable) recently have done, without necessarily affecting credit quality. Also, acquisition activity may rise, particularly in the software and services sectors.
Maturing growth, globalization, and the need for IT concerns to be broad-based providers may spur consolidation in sectors that have both well-capitalized market leaders as potential purchasers and narrowly focused or inconsistently performing companies as potential targets.
Credit trends in the telecom-equipment sector are finally on an upswing after a three-year downward spiral, although Nortel (NT) remains on CreditWatch, with developing implications. Telecom-equipment revenues for 2004 will stabilize, enabling the recent massive industry restructuring efforts to restore operating profitability for the major global players.
Semiconductor revenue growth should exceed the 20% range this year and then decelerate to high single-digit growth next year. Several negative outlooks have been stabilized as earnings improved with revenue growth in the sector. Software and services should continue to be the most predictable performers, although software-license revenue has been pressured at several companies.
The contract-manufacturing sector is expected to experience moderate revenue increases, in line with tech markets overall. Ratings have stabilized in this sector at lower levels. However, profitability continues to be pressured by overcapacity and the considerable pricing leverage held by customers of large original-equipment manufacturers (OEMs) customers.
Here's a sector-by-sector review of financial -- and ratings -- trends for each of the key IT groups. A full list of rated companies, with S&P comments on each, is available at Standard & Poors Web site.
Semiconductor Manufacturers
The sector's growth rate has moderated in the past few months. After robust expansion -- sales for the 12 months through June, 2004 were 27% above the prior 12-month period -- several companies have announced likely flat to down September-quarter sales as customers absorb inventories that have built up in recent months. Because the September quarter usually is somewhat muted, a clear interpretation of this recent news can be difficult.
We believe December-quarter sales largely will be flat with September, and that growth will continue at a more muted pace in 2005. Long-term industry expansion is expected to be in the 8% to 12% range.
The capital-goods sector also has been recovering, particularly for companies supplying the most advanced technologies to microprocessor and memory makers, as well as foundries. Most other chip companies don't require extremely fine feature sizes. Overall, capital-goods sales didn't expand as fast as expected, and near-term prospects could well be muted as the chipmakers pause to assess their own prospects for the next few quarters.
Modest outlook improvements are expected as companies stabilize their financial profiles in the recovery, but significant rating changes are unlikely.
Communications-Equipment Manufacturers
Rapid change continues in this sector as traditional land-line traffic shifts toward wireless and cable platforms. Supplier-customer relationships could change because the phone, IP, and cable operators' equipment have come from three separate sets of manufacturers, with little overlap.
Equipment suppliers' cost structures are now about right for current business levels, and the corporate-credit ratings for Alcatel (ALA; BB; stable) and Lucent Technologies (LU; B; positive) were raised earlier in the year, reflecting improving operating and financial performance. The ratings for Nortel Networks (B-) remain on CreditWatch, pending release of audited financial results and a better assessment of near- to intermediate-term performance.
Computer Manufacturers
The outlook for U.S. computer-hardware spending is moderately optimistic. Although double-digit unit-volume growth rates are expected, highly competitive pricing conditions will moderate sales growth levels. Corporate spending on computer hardware is expected to grow in the mid- to single-digit range in 2004, with stronger demand for Intel and Linux-based servers. Spending on high-end systems -- especially on UNIX platforms -- is expected to be flat to slightly lower.
Over the longer term, the need for continued investment in wireless, E-commerce, and Web-based technologies should continue to support hardware spending growth. However, despite a positive spending outlook, highly competitive industry pricing conditions will continue to pressure computer-hardware profitability for most OEMs.
Electronics DistributorsImproving levels of technology spending are evident in the electronic-components and computer-products distribution sector. Industry growth is expected to be in the 5% to 10% range for 2004, with rates at the upper end of the range for broad-line, global distributors that participate in multiple sectors and benefit from higher-growth locations.
Rating outlooks in the electronic-components sector remain negative, based on weak earnings and debt-protection measures. However, we expect earnings to improve on a year-over-year basis through 2004. Rating outlooks are stable in the computer-products distribution sector, reflecting consistent profitability and less leveraged financial profiles than the components distributors.
Contract Manufacturers
Sequential revenue growth for the electronics manufacturing services (EMS) sector likely will moderate over the near term as rising inventories in the supply chain -- particularly computing, storage, networking and telecom -- have slowed orders. Most companies continue to experience favorable operating leverage, albeit very gradually, as benefits from restructurings and low-cost manufacturing translate into higher EBITDA margins.
Balance sheets remain strong, with most companies generating positive cash flow, indicating the market likely will remain fragmented and intensely competitive through the next business cycle.
One significant departure from the group is Celestica (CLS; BB), which announced sales and earnings shortfalls this quarter. This rating was placed on CreditWatch, with negative implications over concerns about falling profitability, negative cash flow, and increasing leverage.
Software Service Providers
Of the 46 rated companies in this sector, 20 are rated investment grade, while the outlooks for 70% of the total are either stable or positive. The relative stability of this sector is supported by a high proportion of service revenues under long-term contracts, providing a solid recurring revenue base and a better degree of visibility than other high-technology sectors.
Based on recent trends and earnings announcements, it appears corporations are loosening their purse strings somewhat and beginning to reinvest more in IT infrastructure. However, most rated software and services companies remain cautious, and continue to realign their cost structures. Most maintain adequate financial flexibility to cushion any near-term volatility.
Overall business fundamentals remain strong, the industry is still highly fragmented, and well-entrenched companies should continue to perform well over the long term. Consolidation activity has accelerated recently, especially for companies that are prominent in national defense initiatives. We expect this trend to continue as companies expand critical mass and technical expertise.
European Semiconductor and Passive Electronic-Component Manufacturers
This group continued to report good results in the second quarter of 2004. The ongoing solid performance was reflected in two positive actions, with the outlooks on B+-rated ASM International (ASML) and BBB-rated EPCOS changed to stable from negative, as good performance allowed the companies to restore their financial profiles.
Overall, all rated European players showed solid, but not exceptionally strong results in the first half of 2004 on rising volumes and a better pricing environment. Forecasts remain healthy for the remainder of 2004 and 2005.
Growth in 2005, however, is expected to be weaker than 2004, with only low double-digit growth. This trend also has been highlighted by an increase of 8% in German semiconductor sales in August, 2004, following 12% rise in July and 18% rise in June. Adverse fluctuations in the euro/U.S. dollar exchange rate will continue to be monitored closely, as will the strength of the European wireless industry -- the latter a key market for these participants.
We believe most European semiconductor-related manufacturers recently have built sufficient financial flexibility to protect credit quality in the near term.